Those seeking to become limited partners in a venture capital fund may benefit from understanding the basic mechanics of venture capital, before going on to more advanced notions. This includes fund topics such as fees, commitments, carry, returns and structures.
Important to note that these mechanics are often dependent on many factors such as region as well as the individual fund and what is outlined in the Limited Partnership Agreement.
Table of Contents
Structure
Venture capital funds are often structured as closed-end entities. This means that the fund has a predetermined period upon which it will dissolve and returns will be distributed to the LPs. Most VC fund periods are for 10 years as startups take time to mature and yield returns via exits / acquisitions or IPO’s. Usually, there are two years of extensions without fees. In sectors such as DeepTech, the fund duration maybe longer, as these sets of companies take much longer to mature.
On the other hand, evergreen (open) fund structures have no termination date and are more liquid. However, they are very difficult to manage for small to medium funds and are usually adopted by large global multistage firms.
Returns in both structures will be distributed to investors at the discretion of the fund manager and provided a portfolio company has yielded sufficient returns. For closed-end structures, this can also happen before the termination date of the fund. In open-end funds, the manager may choose to hold on to the asset even post IPO.
Capital Commitments
Usually, limited partners will commit a certain amount of capital to the fund. However, important to note that the entire sum is not invested initially. Typically, a fund manager will ‘call capital’ several times throughout the fund’s lifetime; usually, this is between 20%-30%. You may also see that in some funds no single LP makes up more than 10% of the fund.
With this capital, managers will finance a portfolio of startups in exchange for equity. Consequently, though an LP is obligated to meet capital calls upon request by the fund manager, they will still be in possession of the capital up until each call.
Partners of the fund are often expected to commit capital during calls as well. This ensures that there is an alignment of incentives for those managing the fund. Depending on the firm, this commitment on the part of the partners is around 1% of the fund.
Fees
VC funds will charge fees to run the management company. This capital is used to pay the salaries of the fund managers, the staff as well as other operational costs such as rent.
Typically, this amount is between 1-3% per year depending on the fee structure. Over the life of the fund fees typically add up to 10-20%. At times, this number can be capped, especially in larger funds that manage vast sums of capital.
Fees may be structured as a flat 2% per year for the duration of the fund, or, as a cascading structure that starts off higher but averages out to 2% over the fund’s lifetime.
The cascading structure is more appealing to new fund managers as the fund’s need for capital is not evenly distributed. Usually, new funds need more cash at the beginning to set up and prefer the cascading structure. Also, fund managers will construct their portfolio at the start of the fund and mostly make follow on investments in the latter half of the fund’s life, meaning they will not need as much money towards the end of the fund’s lifetime.
Carry
Limited Partners of the fund are usually entitled to their investment into the fund, after which the profits are split between the LPs and the GPs. Profit here is defined as any income after the initial fund is returned.
This split is usually a predetermined ratio of the fund’s profits, again, this is outlined in the ‘Limited Partnership Agreement’ which is signed by all parties. Typically this split is 80:20, between the investor and the fund manager, however is subject to change and negotiation depending on the track record of the manager.
Within the fund, you may observe a hierarchical structure upon which the Managing Partners sit at the top. Each partner’s level of carry and capital contributions depends on their seniority, where more senior partners are entitled to more carry but typically have to contribute more capital.
Returns
Venture capital is considered a very risky asset class as over 80% of startups fail. 3X returns are typically seen as the bar for funds, however, less than 10% of VC firms return this much capital. The funds that do outperform the market capture outsized returns. We dive deeper into this in our ‘Why invest in Venture Capital?’ article.
Though VC has outperformed every other asset class in the last 3 years, it is clear that the Pareto Principle is at work within VC funds. Limited Partners should be aware of the expected levels of returns from VC, as it differs across stage and sector of focus. It should be noted that new fund managers tend to outperform existing managers and small funds also tend to outperform very large funds.
Returns from VC funds are typically seen in 8 – 12 years. After raising a fund, managers will deploy some given percentage to construct the portfolio in 2-4 years. They will then keep the remainder of the funds capital in reserve, in order to back the winners in the portfolio. Typically VC funds will raise two funds before investors can get a good picture of how the initial portfolio is doing and so the third fund is crucial for new fund managers.
Reserves
As mentioned, VCs will keep a considerable amount of capital to back the fund’s winners. This is because of the inherent power law in VC where a majority of the returns are derived from a handful of companies.
VCs want to keep capital in reserve in order to back their winners and keep the same percentage in ownership. These winners become abundantly clear as the fund matures and VCs usually have pro rata rights to invest in subsequent rounds. Interestingly, there is some debate among VCs about whether it is prudent to invest in new companies, rather than backing companies in flat and down rounds.